Currency Crises And Banking Panics - Yale University

Currency Crises and Banking PanicsCostas ArkolakisTeaching fellow: Federico EspositoEconomics 407, YaleMarch 2014

OutlineCurrency CrisesCurrency and the Money MarketA Model of Currency CrisesBanking Panics

Currency CrisesA Currency Crisis (or Balance-of-payment crisis) is a sudden devaluationof a currency which often ends in a speculative attack in the foreignexchange market. In such a situation the government is typically unableor unwilling to meet its nancial obligations.These di culties for the government may manifest in a variety ofways: i.e., failure to honor the domestic and/or foreign public debt,suspension of currency convertibility, etc.

Currency CrisesOftentimes, a balance-of-payment crisis arises when government pegs thenominal exchange rate and at the same time, it runs a scal de cit.Recall from previous lectures that under a xed exchange rate regime, thegovernment must nance any scal de cit by running down its stock ofinterest bearing assets (or accumulating debt).Obviously, such a situation cannot go inde nitely.A balance of payments or currency crises starts after that.

Currency Crises: Ways OutThere are three (unpleasant) ways out of such a crises:1Reduce government scal spending or increase taxes: reduce de cit.

Currency Crises: Ways OutThere are three (unpleasant) ways out of such a crises:1Reduce government scal spending or increase taxes: reduce de cit.2Default on past debt and as a result, reduce interest payments.

Currency Crises: Ways OutThere are three (unpleasant) ways out of such a crises:1Reduce government scal spending or increase taxes: reduce de cit.2Default on past debt and as a result, reduce interest payments.3Abort the exchange rate peg and monetize the scal de cit.

Currency Crises: Ways OutThere are three (unpleasant) ways out of such a crises:1Reduce government scal spending or increase taxes: reduce de cit.2Default on past debt and as a result, reduce interest payments.3Abort the exchange rate peg and monetize the scal de cit.Examples of abandoning the currency pegCurrency pegs implemented in Argentina, Chile & Uruguay in the late ’70s,also known as tablitas, ended with large devaluations in the early ’80s.More recently, Brazilia Real plan 1994 & Argentina peso-dollar parity 2002.In Argentinian case, that came with a default on dollar denominated debt.

Currency Crises: SymptomsExtreme pressure on domestic currency, leading to capital controls and theemergence of a black market for foreign currency.Typically the last days before the collapse of xed exchange rate, thecentral bank looses vast amounts of reserves.- Run by the public in anticipation of the impending devaluation.Figure: Foreign Reserves of Argentina (source: IMF)

Currency Crises: SymptomsBank runs on bank accounts in foreign currency.Figure: Depositors protest the freezing of their dollar-denominated accounts(source Wikipedia)

Case Study: Black Wednesday1987: UK follows a semi-o cial policy that pegs the UK poundpreventing the currency from ‡uctuating more than 6%.

Case Study: Black Wednesday1987: UK follows a semi-o cial policy that pegs the UK poundpreventing the currency from ‡uctuating more than 6%.1990, Oct: O cially joins the European Exchange Rate Mechanism(ERM) commiting to this policy.

Case Study: Black Wednesday1987: UK follows a semi-o cial policy that pegs the UK poundpreventing the currency from ‡uctuating more than 6%.1990, Oct: O cially joins the European Exchange Rate Mechanism(ERM) commiting to this policy.1992: UK pound comes under extreme pressure due to high Germaninterest rates and other turmoil in ERM. Prime Minister Majorincreased interest rates and spend billions of pounds worth of foreigncurrency to support the pound.

Case Study: Black Wednesday1987: UK follows a semi-o cial policy that pegs the UK poundpreventing the currency from ‡uctuating more than 6%.1990, Oct: O cially joins the European Exchange Rate Mechanism(ERM) commiting to this policy.1992: UK pound comes under extreme pressure due to high Germaninterest rates and other turmoil in ERM. Prime Minister Majorincreased interest rates and spend billions of pounds worth of foreigncurrency to support the pound.1992: Investors kept selling pounds for foreign currency; on 16 Sept,UK decided to abandon the ERM.

Case Study: Black Wednesday1987: UK follows a semi-o cial policy that pegs the UK poundpreventing the currency from ‡uctuating more than 6%.1990, Oct: O cially joins the European Exchange Rate Mechanism(ERM) commiting to this policy.1992: UK pound comes under extreme pressure due to high Germaninterest rates and other turmoil in ERM. Prime Minister Majorincreased interest rates and spend billions of pounds worth of foreigncurrency to support the pound.1992: Investors kept selling pounds for foreign currency; on 16 Sept,UK decided to abandon the ERM.George Soros short sold 10B worth of pounds with a pro t of 1Bduring that crisis (source: Wikipedia)

Currency Crises: TimingTypical timing to the crisis:A country pegs its currency exchange rate.

Currency Crises: TimingTypical timing to the crisis:A country pegs its currency exchange rate.The government needs to intervene in the foreign exchange marketto support the currency. Foreign reserves slowly deplete.

Currency Crises: TimingTypical timing to the crisis:A country pegs its currency exchange rate.The government needs to intervene in the foreign exchange marketto support the currency. Foreign reserves slowly deplete.A sudden speculative attack depletes the foreign reserves and forcesgovernment to abandon the currency ‡oat.

Currency Crises: TimingTypical timing to the crisis:A country pegs its currency exchange rate.The government needs to intervene in the foreign exchange marketto support the currency. Foreign reserves slowly deplete.A sudden speculative attack depletes the foreign reserves and forcesgovernment to abandon the currency ‡oat.) We will study a model of currency crises with these features(Krugman, 1979, Journal of Money Credit and Banking)We will use the model of nominal exchange rate determination whichwe have already studied.

Currency and the Money Market

Currency and the Money MarketTo refresh our memory, we rst consider what happens when theexchange rate is free to ‡uctuate.We consider a speci c monetary policy in which the central bank(CB) expands money supply at a constant rate: Mt (1 µ) MtSet foreign price Pt 1 ) Pt Pt Et Et .1.

PPPPPP holds:Pt 1 1 µPtAssume (we will eventually prove):Et 1 1 µEt

Uncovered Interest ParityUsing the uncovered interest rate parity condition, we solve for thedomestic interest rate:1 it (1 r )where it r if µ 0.Et 1 (1 r ) (1 µ )Et

Uncovered Interest ParityUsing the uncovered interest rate parity condition, we solve for thedomestic interest rate:1 it (1 r )Et 1 (1 r ) (1 µ )Etwhere it r if µ 0.Denote this dependence it it (µ). Money market equilibrium yieldsMtMt L (C̄ , i (µ))PtEtNotice that RHS is constant. Take di erencesMt 1 /Mt Et 1 /Et 1 µproving our conjecture.

Government Budget ConstraintRecall government budget constraint:BtgBtg1 Mt MtEt{z1}seignorage revenue MtMtEt1Gt Tt{zr Btg1real secondary de citDEFt}

Government Budget ConstraintRecall government budget constraint:BtgBtg1 Mt MtEt{z1}MtMtEt1Tt{zr Btg1real secondary de citseignorage revenue Gt DEFt}Can the government cover the de cit using seignorage revunue? Usingmoney market equilibrium:MtEtMtEtMtMtEtMtEt L (C̄ , i (µ)) )1 L (C̄ , i (µ)) 11 L (C̄ , i (µ))1)1 µµ 01 µ

A Model of Currency Crises

A Model of Currency CrisesWe use a model to solve for endogenous variables:nominal exchange rates,price level,real balances,domestic interest rate.Assume that initially the government has to maintain a peg.Three phases:123Currency PegCurrency CrisisCurrency Floats

Phase 1, Currency PegFrom period 1 to period T 2 : exchange rate is pegged.Exchange rate xed, Et E , & let foreign price xed Pt 1.By PPP: Pt Et Pt ) Pt E1Interest rate xed: 1 it (1 r ) EEt t 1 1 rGovernment cannot monetize de cit, and thus money supply stayst xed ML (C̄ , r )E t L (C̄ , r ) ) Mt EBy government budget: BtgBtg1 DEFt

Phase 2, Currency CrisisPeriod t T 1 : peg has not collapsed yet, PTExchange rate is expected to ‡oat next period.Expected depreciation: ET /ETBy PPP: PT1 ET1 PT1Interest rate changes: 1 iTMoney market: MT1 /E1 ET1 E. 1 µ (we will not prove that). ) PT111 E1 (1 r ) EETT 1 (1 r ) L (C̄ , i (µ)) L (C̄ , r ) MT2 /EMoney supply decreases, people use the domestic money to buyforeign currency.Reserves drop sharply since foreign currency is relatively ‘cheap’.

Phase 2, Currency Crisis

Phase 3, Currency FloatsPeriod t T onwards: country runs out of reserves BTgLet us assume that it cannot borrow (BTg 1 0).1 0.Exchange rate ‡oats:Government can monetize debt; it expands money supply at a rate µ.By PPP: Pt Et Pt s ) Pt Et1Interest rate xed: 1 it (1 r ) (1 µ)By government budget: BtgBtg1 DEFt

Banking Panics

Banking PanicsBanking Panics happen when the public, fearful that their banks will notbe able to convert their deposits into currency, attempts en mass towithdraw their deposits.Historically, dozens of banking panics starting from the 18th century.Most famous ones: Panic of 1907, Great Depression, most recentone in Cyprus 2013.

Banking Panic of 1907

Banking Panics: TheoriesSelf-ful lling expectations (because of the imposed rst-come- rst servedrule for withdrawing the deposits) could lead to a bank runIf depositors believe that many other depositors will run to the bank towithdraw their money, they will run to be the rst.Such a run could be triggered by some change in fundamentals or even byfalse information.

Banking Panics: TheoriesSelf-ful lling expectations (because of the imposed rst-come- rst servedrule for withdrawing the deposits) could lead to a bank runIf depositors believe that many other depositors will run to the bank towithdraw their money, they will run to be the rst.Such a run could be triggered by some change in fundamentals or even byfalse information.Information asymmetry does not allow depositors to accurately assess abank’s risk.Unexpected failure of a corporation or a major recession may leaddepositors to inaccurately assess bank’s liabilities, because bank assets arenon-traded.They may withdraw money from the bank and cause a panic.

Testing the TheoriesGorton (Oxford Economic Papers ’88) tests the second hypothesis (aboutinformation asymmetry) in the data and nds some evidence:He uses an indicator variable predicting a recession.He nds that when the indicator reaches a certain level (very likely to be arecession) a banking panic occurs.

The Spread of Banking PanicsIn a globally linked nancial system, banks are also interconnectedthrough their balance sheets.Banks hold assets from other banks; the default of one bank, even overseas,could lead to a widespread banking panic.Recent example, the subprime mortgage crisis in the US, that spreadthroughout the US, Europe (UK, Ireland, Spain), and the rest of the worldby a ecting the balance sheets of banks.

The Recent Banking CrisisBanks were holding many assets based on loans of lower quality(lower probability of repayment)That was not a problem as long as house prices were increasingbecause loans not serviced could be paid by selling the house (byhome buyer or bank)When the house prices collapsed many loans could not be servicedThis led to sharp devaluation of banks assets and a suddendisruption of banking credit

Lender of Last ResortThe policy of the central bank of a country providing liquidity todistressed banks (or even pledging to do so) has led to a severe reductionin the incidences of banking panics.But if banking regulation/screening is loose crisis might happen throughother channels as we just discussed

Currency Crises: Ways Out There are three (unpleasant) ways out of such a crises: 1 Reduce government -scal spending or increase taxes: reduce de-cit. 2 Default on past debt and as a result, reduce interest payments. 3 Abort the exchange rate peg and monetize the -scal de-cit. Examples of abandoning the currency peg Currency pegs implemented in Argentina, Chile & Uruguay in the late .